Certainties: Death, Taxes, And Change

My best tax advice: keep up with tax laws. You don’t have to become a tax expert but learn enough to 1) plan your strategies and 2) ask the right questions of your CPA if you choose to hire one. Don’t let current tax laws rule your planning decisions (why? because they’ll change) but be aware of tax implications for generating income and taking deductions.

When my youngest son was born in early 1997 (before the Taxpayer Relief Act of 1997 - PDF), the tax-advantaged way to save for his college education was through a UTMA/UGMA account. Did caring for a baby and tending to his older brother distract me from keeping up with changes in IRS legislation? Yes! Meanwhile, before my child finished elementary school, tax laws relating to college education savings changed three times!

College Education Savings

My Plan A: UTMA/UGMA (Uniform Transfer to Minors Act/Uniform Gifts to Minors Act). I set up an account in my son’s name so that unearned income (capital gains on investments) would be taxed at his rate, which typically would be lower than mine. The upside to this arrangement was the lower tax liability; the downside was that UTMA/UGMA investments would be classified as his assets when he applied for financial aid. (Note: assets in these accounts are to be used for the child but not necessarily designated for education.)

My Plan B: Coverdell Education Savings Account formerly known as Education IRA. The Education IRA (now Coverdell ESA) and Qualified Tuition Programs (generally called 529 plans in reference to the section of IRS code referring to these programs) were introduced in late 1997. The Coverdell allows me to set aside money for my children’s education and receive a tax deduction of up to $2,000 per year (note: there are income restrictions and contribution caps on this savings mechanism). Capital gains on investments held are not taxed and distributions for qualifying expenses are tax-free. Depending on the classification of the account when opened, a Coverdell may be treated as a parental asset or a child’s asset when he applies for financial aid.

My Plan C to complement Plan B: Qualified Tuition Programs commonly known as 529 Plans. These have been around a while but just recently (January 2007), tax advantages associated with the plans have been made permanent through The Pension Protection Act of 2006. No tax deduction is available with these accounts though annual contribution limits (without incurring gift taxes) are much higher and there are no income restrictions. No taxes are incurred on investment gains and money can be taken out tax free to pay for allowable educational expenses. Accounts can be owned by children, parents, and even grandparents with varying financial aid implications.

Retirement Savings

According to the Legislative History of IRAs, the tax law allowing Individual Retirement Accounts (IRAs) were introduced in 1974. Actually, I thought that President Reagan had created them in 1981 though really what happened was they became available to a bigger group of people. I found it odd that the same administration that allowed taxpayers to contribute to IRAs then added restrictions. Here’s a rundown on some of the legislative changes:

1974 – Those not covered by a qualified employer-based retirement plan can contribute to (and receive a tax deduction for) a traditional IRA by up to $1,500.

1978 – SEP-IRA (Simplified Employee Pension Plan-IRA) is introduced for small businesses (primarily) and the self-employed.

1981 – All taxpayers and those employed under 70½ years old can contribute to (and receive a tax deduction for) a traditional IRA by up to $2,000 and put in $250 for a nonworking spouse.

1986 – Tax deduction on traditional IRAs is phased out for higher-earning workers covered by an employment-based retirement plan or whose spouse is covered.

1997 – Roth IRA is introduced that allows taxpayers (under certain income restrictions) to save for retirement while avoiding capital gains on investment trades and avoiding taxes on withdrawals.

2000s – Contribution limits and income restrictions keep changing!

Interest Deductions

Interest on consumer loans (credit cards, auto loans) used to be tax deductible but those deductions were phased out in the 1980s. Mortgage-based loans retained the interest deduction and, based on my observations, home equity loans and home equity lines of credit became more and more popular. For an entertaining, informative look at interest deductions, specifically the public policy behind mortgage interest deductions, see “Who Needs the Mortgage-Interest Deduction?” (New York Times) by Roger Lowenstein.

Capital Gains on Primary Residences

Once upon a time, homeowners could avoid capital gains tax on the sale of their primary residence one time in a lifetime, unless they plowed those profits right back into another home purchase. Now, homeowners can get this deduction as many times as they'd like (with no capital gains tax due on profits $250,000 and less) according to a Bankrate.com article on Capital Gains Home Sale Tax Break.

Section 179 Deduction for Business Owners

When I first started my business, I was thrilled to be savvy enough about tax laws in general and the Section 179 deduction in particular to know that I could expense, rather than depreciate, the cost of fixed assets (my computer for example).

To illustrate the changes in tax law, at one time, the Section 179 deduction had a cap of a few thousand dollars (that is if you bought a computer for $2,000 and the Sec. 179 cap was $5,000, then you could take a full deduction for the cost of the computer rather than spreading its cost over 5 years and taking $400 deductions each year). For more on this fascinating topic, see Section 179 Tax Deductions.

A few weeks ago, I was reading a personal finance article and the topic of Section 179 deductions was mentioned. When I saw the dollar amount that the author said you could deduct, I was sure it was a misprint, most likely a misplaced comma. I did some research and discovered that in 2008, a business owner can make a capital investment of $125,000 and deduct the full amount. Amazing! Apparently, a major increase in the deduction took place in 2003, when the limit was raised from $25,000 to $100,000. It looks like this generous deduction is available through 2009.

Long-Term Capital Gains on Investments

The tax rate on long-term capital gains is typically lower than ordinary income rates, varying from 5% to 28% depending on income levels for the past several years. In 2008, however, lower-earning taxpayers will be exempt from capital gains taxes (that's ZERO on long-term assets such as equity investments but not counting collectibles and small business stock). According to Bankrate.com, "To qualify for the zero rate in 2008, a married couple must make no more than $65,100 in taxable income; single filers earning $32,550 or less will pay no tax on their sales of assets they've owned for more than a year." This deal is available until 2010 unless, of course, tax laws change again. (Warning: long-term capital gains generated by the sale of investments are included in taxable income).

Coasting along with financial vehicles and investment strategies aligned with outdated tax laws may be dangerous. Stir in frequent changes to your personal circumstances and you’ll cook up some not-so-great decisions.

Note: I am not a tax expert or CPA, so please consult the IRS or a tax professional in regard to tax questions. I hope this post has helped you figure out what some of those questions should be.

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I hadn't been thinking about a flat tax when I was writing this but I can see the value based on tax law complexity and changes. Given the assumption that our tax structure should reflect public policy (encouraging savings for college, retirement savings, home buying), I actually feel a bit of empathy with Congress, having to change tax laws to keep up with society (high college costs, need to replace pensions with personal savings).

But it would be interesting to know whether people even know about all these rules (I have Coverdell accounts for my kids but didn't realize that withdrawals were tax-free, under provisions) and see how people's habits actually change based on tax-law changes.

I might get overwhelmed, pfodyssey, thinking about possible changes, though imminent ones might be interesting to follow. A recommendation from The Quiet Millionaire author was to use tax-advantaged and taxable accounts (401(k)s, Roths, regular investments) b/c you never know how things will change and you can hedge your bets. Thanks for reading!